Are Funds of Hedge Funds Worth the Expense?

A typical solution proposed by Wall Street for all the bad news floating around the financial press is to use hedge funds. The increased flexibility of these vehicles is supposed to allow them to protect investors. And a fund of hedge funds strategy is supposed to add even more value by bringing an added layer of oversight and more diversification than a single-fund approach -- producing more consistent, less-volatile returns.

Unfortunately the evidence doesn't support any of the hype. Not only have returns been poor, but funds of funds have even failed to perform their important function of due diligence, as evidenced by the losses incurred in the Bernie Madoff scandal.

The performance results have been no better. While investment management firms running "funds of funds" continue to tout their superior fund-manager selection skills, the July 2010 issue of Private Wealth provided some evidence on the performance of funds of hedge funds:

• Over the past 12 months through April, the average individual hedge fund gained 19.7 percent while the average fund of funds gained 12.6 percent, a drag of 7.1 percent. Over the last three years, hedge funds gained an average of 2 percent annually while the average fund of funds lost 1.9 percent, a drag of 3.9 percent a year. And over the prior five years individual funds gained an average of 6.6 percent annually, outpacing funds of funds by 3.2 percent a year.
• In 2009, individual hedge funds returned more than 21.5 percent while the average fund of funds gained only 9.4

You might conclude, as Warren Buffett did, they're not investment vehicles at all, but simply "compensation schemes," likely to enrich only the fund owners, managers and those promoting their use. Investors should be especially cautious regarding reported returns data -- the data doesn't appropriately reflect the risks of hedge fund investing, and it's likely to be biased in favor of hedge funds.

Here's what David Swensen, CIO of the Yale Endowment Fund, had to say on funds of hedge funds: "Funds of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital."

The data suggests that there is a more efficient way to achieve diversification from domestic equities. Invest in low-correlating asset classes, such as international small-cap value, emerging markets, real estate, TIPS and perhaps commodities (in the form of a fund investing in fully collateralized commodity futures). All of these asset classes can be accessed through low-cost, passive investment vehicles.

More on MoneyWatch:
TIPS Update for December Why You Shouldn't Be Scared of Low Interest Rates Active Managers Continue Lagging Their Benchmarks The End of Social Security's Interest-Free Loan Is International Diversification Worth the Costs?
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.